Global Macro Notes: The Deflationists Are Still In It To Win It

Let's begin with an interesting observation. From the time QE2 was initiated, the $USD is actually higher, not lower.

This is especially curious given that the euro - the major forex counterweight in the $USD index - has not collapsed.

Dial back the clock to November, when many were predicting QE2 as a watershed event. China's ministry of commerce spoke of "continued and drastic US dollar depreciation." The imminent death of the dollar was (and still is) a widespread refrain.

Yet the buck is higher now. What gives?

Something else to consider - a long-term chart of 30-year US Treasury bonds, which have maintained a big picture bull market stance since at least the year 2000.

Along with the death of the dollar, a quite popular prediction is the ultimate demise of the U.S. bond market. Treasuries have been called a "suicidal" investment. Nassim Taleb at one point opined that "every human" should be short treasuries.

And yet, the long-range uptrend remains intact. Perhaps the reaper is coming, but he's still got some heavy lifting to do. For debt armageddon to hold water as a prophesy, we'll really need to see that long-term trendline decisively broken.

Nor should the demise of the bond market be taken as a foregone conclusion. In fact, some are betting with conviction that USTs are still a good place to be.

Like deflationist Gary Shilling, for example, who offers the following as his top investment strategy for 2011:

1. Buy Treasury Bonds. We're deliberately listing this strategy first not because of nostalgia, although this strategy has worked for us for 29 years on balance, and has been our most profitable investment. Instead, it's because we expect further substantial appreciation with 30-year Treasury bonds, and because so few other investors believe our forecast has any chance of being realized. Fundamentally, we favor Treasury bonds…

—Because we foresee slow economic growth at best in coming quarters and years

—Because the Fed is determined to further reduce interest rates

—Because deflation is looming

—Because long Treasury bonds are attractive to pension funds and life insurers that want to match their long-term liabilities with similar maturity assets

—Because as the U.S. moves ever closer to the slow growth and deflation of Japan, the parallel trends in government bond yields seem likely to persist

—Because Treasurys are the safe haven in a sea of trouble in the Eurozone and elsewhere

—Because China's attempts to cool her economy will probably precipitate a hard landing

—Because the likely price appreciation in Treasurys is in stark contrast to expensive stocks and overblown and vulnerable commodities, foreign currencies, junk securities and emerging market stocks and bonds. We continue to predict that 30-year Treasurys, "the Long Bond," will rally from its current yield of about 4.4% to 3% with appreciation of around 2.6%. Similarly, a 30-year zero-coupon Treasury would gain 48%. We also expect the 10-year Treasury note yield to drop from the present 3.3% level to 2.0%. but the appreciation would be only 11%, largely because of its shorter maturity.

Takes all kinds to make a market eh?

The point here is not to take sides in the great inflation versus deflation debate. (We are neither bulls nor bears, but Mercenaries. The same applies to economic labels.)

Instead, the takeaway is that the deflationists are still very much "in it to win it."

In spite of all that's happened these past few months, there are still logical (and some would say compelling) arguments as to why deflation is still the dominant force in the world, with inflationary upticks merely a red herring.

In fact, there is a case to be made (as we shall articulate now) that the market-based inflation signals generated these past few months were little more than a giant QE2-related headfake.

1) Widespread belief that QE impact is inflationary leads to 2) Widespread action to protect against dollar debasement, which fuels 3) A persistent rise in the price of [commodities / hard assets], creating 4) A self-reflexive feedback loop reinforcing 1), with the final result of 5) Companies facing significantly higher material input costs, which are 6) Correctly labeled as inflationary! (Or perhaps stagflationary.)

The gist is that whether or not quantitative easing actually had the mechanical effects intended by the Fed - in terms of lowering bond yields - it is quite possible that investor anticipation and interpretation of QE2 effects spurred the most visible results.

Think of this like a "Wall Street placebo." Numerous studies have shown that placebos - inert sugar pills delivered in the guise of medicine - can actually have tangibly positive effects on patient recovery cycles.

And so, in some ways QE2 and the "Bernanke Put" can be viewed as a giant "inflation placebo," convincing investors to move out on the risk curve, further reach for yield, and buy up inflation-favored hard assets.

This, of course, is far from the desired cause and effect… the supposed goal of QE2, if you'll remember, was to keep bond yields low in order to support the economic recovery. But the Federal Reserve failed utterly in this goal. Bond yields went UP, not down - and in fact QE2 may have been directly responsible for this impact as the "inflation placebo" caused investors to move out of treasuries!

Think of it like this:

In the minds of investors, QE2 is widely accepted as a market-supportive mechanism with inflationary force. (In otherwords, investors view QE2 as the attendant equivalent of "printing money," whether or not this is true.)

As a result of this belief, investors shift their preferences further out on the risk curve. In so doing, they take money out of treasuries and put it into risk assets.

Yields rise as a result of this preference shift, with risk appetite facilitating a move out of treasuries (causing forementioned rise) and into more speculative vehicles (copper, energy stocks, etc.)

Nobody cares, though, because all parties can claim results-based success. The Bernanke Fed can claim QE2 is a success because the stock market has gone up, and Wall Street can ignore rising bond yields against a backdrop of renewed risk appetite and modestly improving economic conditions (which were already in the pipeline).

Can you see how crazy this is? Independent of tactical decisions as to what to buy or sell next, the above chain of events shows that the Federal Reserve is clueless. In their efforts to appear sober and in control, the Fed ladles calculation upon comedy.

To wit, Bernanke et al don't really know what they are doing, they can't really predict the effects of their mad experiments, and they are happy to take credit for temporarily serendipitous outcomes which, to a large degree, were not intended or expected at all!

And yet these are the mighty financial gate keepers who, with great sobriety and gravitas, assure us they have "100% confidence" (to use a Bernanke phrase)…

Now let's cycle back around to the deflationist case. There is a clear argument here - put forth by us some time ago - that the impact of Quantitative Easing has been mainly psychological. That is to say, it may not have had any of the effects Bernanke expected other than getting investors hot and bothered, increasing risk appetites and "animal spirits."

But "animal spirits" are fickle and can fade - or be crushed under the weight of denied realities once again pressing in…

Consider another very real impact of QE2 (as a result of hard asset resurgence): What we call "the E.M. Hiking Cycle," i.e. the need for developing countries around the world to hike interest rates, or otherwise hit the brakes, in order to fend off mounting inflation pressures.

Outside America, food has a bigger share than energy in consumers' shopping baskets—and thus in inflation too (see chart). In developing countries, rising food prices can be a human as well as an economic disaster. In Asia in early 2008 a spike in the price of rice led to widespread unrest and desperate attempts by governments to secure more supplies. In December in India, for example, food prices rose at an annual rate of 14%, and there has been a run on onions, a dietary staple.

As well as taxing consumers, or worse, dearer commodities push up overall inflation, as the latest numbers from the euro area and Britain show. Although textbooks suggest central banks should "look through" a one-off increase in commodity prices, which provides only a temporary boost to inflation, monetary policymakers fret about second-round effects.

So here we have another interesting phenomena. Loose U.S. monetary policy is effectively exporting inflation to the rest of the world. The Fed is writing off the inflationary impact of that policy - be it psychology-based or otherwise - because "core" inflation statistics do not show up on the American home front.

When it comes to the food and energy tax, American consumers are not yet boiling like the frog in the proverbial pot. (Though this may also be an illusion perpetuated by the hear no evil, see no evil BLS.)

What's apparent now is that, though Bernanke refuses to tighten, emerging markets are doing the tightening for us. Developing world countries in overheated situations are taking the steps that the issuer of the world's reserve currency won't.

And so the system on the whole is undergoing tightening at the margins, which further contributes to creeping deflationary forces…

Now let's turn to the euro. The euro is stronger, even though the euro zone is still in soft crisis, because it's widely perceived (correctly or incorrectly) that:

The euro is not going to collapse

The ECB (European Central Bank) is run by hawks

The Federal Reserve is run by doves

In contrast to the Fed's clearly stated intent to stay loose come hell or highwater, Jean-Claude Trichet (the President of the ECB) is determined to get his disciplinarian on with communiques like this (via the Wall Street Journal):

Inflation fears—fueled by spiraling food, oil and raw material prices—are mounting around the globe, prompting the head of the European Central Bank to signal that it could raise interest rates in the future even though some countries have been weakened by the Continent's debt crisis.

In an interview with The Wall Street Journal ahead of this week's annual meeting of the World Economic Forum in Davos, Switzerland, Jean-Claude Trichet warned that inflation pressures in the euro zone must be watched closely, and urged central bankers everywhere to ensure that higher energy and food prices don't gain a foothold in the global economy.

Mr. Trichet's warning comes at a time when inflation concerns are mounting among investors around the world. Fast-growing emerging markets such as China and Brazil are seeing rising inflation at home, and their demand for globally traded commodities is pushing prices higher elsewhere.

Thus, even though the austerity gleam in Trichet's eye is a little bit scary, the logic du jour says to be bullish on tight euros (and down on loose dollars)…

But how long can this last? The trouble with the eurozone (and now the UK) is that the austerity hawks are playing chicken with the threat of double dip recession (and creeping economic malaise).

Belt tightening is all well and good - the physical equivalent of diet and exercise - if the economy (or economies plural) can handle it.

But if the unduly sick and weak economy can't handle it, the risk of zealous austerity focus is a rapid worsening of conditions as economic output falls faster than debt is cut back, making the relative burden of existing debt that much greater. (This is the dreaded "downward spiral" that can lead to deflation and depression.)

In other words, Trichet et al run the risk of emulating the FDR administration circa 1937, when a round of premature fiscal tightening sent the post-depression economy back into the crapper.

And this "1937″ scenario may actually be what's playing out in Britain now, as evidenced by the "shock" announcement in which a 0.5% GDP contraction was recorded for Q42010, rather than the expected 0.5% rise. Via the Financial Times:

Sterling put in its worst performance for a month, dropping over two cents against the dollar and hitting a 10-week low against the euro after figures revealed a surprise contraction in the UK economy.

Data showed that British fourth-quarter gross domestic product fell by 0.5 per cent, confounding expectations for a rise of 0.5 per cent and way below even the most pessimistic of analysts' forecasts.

The news raised the prospect of a double-dip recession in the UK economy and dented expectations that the Bank of England would raise interest rates in the near future.

Britain's shock was a body blow to the austerity-minded conservative government, which must now contend with the horrible combination of rising inflation and contracting economic activity.

As with the (potentially) misguided hawks of europe, it's looking like harsh austerity medicine is too strong for the frail constitution of the UK patient.

So where does this end? If Britain and various eurozone periphery countries continue to experience debilitating economic contraction, to the point where fiscal belt-tightening acts like a noose around the neck of the respective recoveries in question, the final result will be some form of emergency monetization - coupled with severe declines in the value of the euro and the British pound - and the one-time hawks will look like chastened fools, as rampant inflation is ultimately tolerated for the sake of saving the system.

This, finally, brings us to perhaps the largest reason why the deflationists are still "in it to win it"… the economic recovery process is still extremely fragile, and thus vulnerable to further shock.

The U.S. economy is mending itself ever so slowly, but this trend can be derailed by a sufficiently weighty crisis event.

The economies of Europe are extremely fragile - and prone to austerity-worsened setback as Britain's GDP contraction shows.

It is not clear how various emerging market economies will respond to aggressive hiking cycles and other measures to crack down on food and energy induced inflation.

The bubble-wracked Chinese economy, meanwhile, is vulnerable to policy shock as a result of internal inflation pressures threatening to rage out of control.

Also to keep in mind: The deflationist stance, defiant in the face of rising commodities, is that the recent rise in hard assets and risk assets in general has been more due to a QE2 "inflation placebo" effect than anything else - and in which case can be reversed by a sufficiently rude jolt to the sysetm.

And so perhaps the strongest justification for being a U.S. bond bull, and a deflationist at the core, is the conviction that some major economic dislocation in the next six to twelve months could deal this tepid, cosmetically superficial U.S. recovery a blow that it struggles mightily to recover from… in which case monetary velocity could again plummet, the "inflation placebo" effect could evaporate, and the $USD and long bonds catch renewed flight-to-safety bids as newly horrified investors disgorge their risk asset holdings and the global economic engine "seizes up" once again.

Not a pretty picture. But a scenario worth considering…

Once again, the deflationist scenario is by no means guaranteed to come about. But the case is certainly plausible, and in the eyes of some compelling.

It really comes back to the question "What odds of crisis" - housing double dip, China hard landing, periphery implosion, muni-bond meltdown etc - which takes us back to our main " Twelve Major Risks for 2011" observation, namely that you can't bank on any one specific crisis occurring in the medium term, but you can note there are enough land mines out there to make the odds of exploding one significantly high (perhaps 50% or better).

How to respond to this breathtakingly uncertain environment, in which rosy scenarios and disaster scenarios plausibly exist side by side?

Perhaps unsurprisingly, our solution is to be vigilant and flexible - and to trade. As a matter of habit and methodology we continue to assess new developments as they unfold (rather than being rigid in our preconceived notions), all the while running a relatively "balanced book" of attractive longs and shorts, and above all letting price action be our guide.